The last few years have been forgettable for Australia's life insurers. Poor customer experience surrounding claims handling and management in 2016 tarnished the industry's reputation, which has recently seen further damage from adverse disclosures as part of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Royal Commission). To make matters worse, the underperformance of the individual income protection line of business continues to hinder the industry's profitability and there are prospects of legislative changes affecting group business that threaten to further erode margins. On top of it all, there is uncertainty surrounding the extent and impact of the Royal Commission recommendations due early 2019. All these challenges reinforce the negative trend we see for the sector.

Royal Commission Disclosures Are Further Undermining Image And Reputation

The disclosures stemming from the Royal Commission have further damaged an industry whose reputation was already tarnished. While disclosures from the Royal Commission have been embarrassing for both the property/casualty and life insurance industries, overall the life insurance sector has experienced greater adverse publicity with revelations including: misleading the corporate regulator, premiums being charged for deceased individuals and advice not provided, inappropriate direct selling techniques, poor claims management practices, and using outdated medical definitions.

With the Royal Commission the hot topic at both the wholesale and retail level, there is a risk that policyholders and large group (superannuation) clients lose confidence in the industry and subsequently lower or withdraw their cover. To date, there is no overwhelming evidence to suggest this is happening. In our view, we are more likely to see an increase in switching between providers, with the beneficiaries being those insurers with good claims paying reputations, especially when it comes to the re-contracting of group schemes.

The tarnishing of an insurer's image can undermine creditworthiness due to a weakening in competitive position or deficiencies in risk management or governance. Moreover, subsequent remediation costs, penalties, fines, and legal action can further impinge on credit quality related to a weakening in capitalization. To date, we have taken rating actions on AMP Ltd. related to disclosures from the Royal Commission (see "AMP Life Downgraded To 'A+'; AMP Ltd. And AMP Group Holdings Ratings Affirmed; Off CreditWatch; Outlooks Negative," published Aug. 30, 2018).

While the Royal Commission recommendations are not due until February 2019, a list of policy questions arising from the insurance round of the hearings was released in late September 2018. The Royal Commission highlighted a number of topics that may be the subject of its final recommendations that cover all aspects of the life insurance industry, including product design, disclosure, sales, claims handling, regulation, and compliance and breach reporting. Moreover, the interim report, though it did not include the life insurance industry, highlighted a number of issues related to conduct, culture, governance, and regulation in the Australian financial services industry. The main risk to the industry, in our view, lies in the potential for far reaching changes in the industry's structure and more onerous and costly regulation.

Individual Income Protection Remains The Problem Child

In our view, the poor performance of the individual income protection line of business will continue to undermine earnings in the life segment, which have declined over the past three years (see chart 1). There are numerous reasons for the troubles with this line of business including: increasing consumer awareness in relation to policy benefits; greater lawyer involvement in the claims process; and a rise in mental illness and stress related claims. Moreover, the business line has been consistently loss-making for the past five years despite the industry's aggressive remediation actions including: price rises and the tightening of terms, conditions, and definitions; and stricter underwriting standards.

The volatile operating performance has been a key driver of divestments of life risk operations by domestic groups, a trend we anticipate will continue.

Chart 1

Proposed Superannuation Legislation Is Bad News For Group Risk Players

The proposed Protecting Your Superannuation legislation continues to cause major uncertainty for life insurers in the group risk segment, over six months after the government first announced the proposed changes. S&P Global Ratings believes the legislation has the potential to significantly hurt the growth and earnings profile of Australia's group risk insurance business, which comprises around 40% of total life insurance premium risk inflows. The package includes proposed changes to the current default arrangements for the provision of life insurance to superannuation members. Under the proposals, trustees will only be permitted to provide insurance on an opt-in basis to new superannuation members under 25 years old, to members with account balances under A$6,000, and to members with accounts that have been inactive for 13 months or more. This is in contrast to current arrangements under which trustees provide insurance to all members on an opt-out basis. To put the magnitude of the potential impact in context, the Commonwealth Treasury estimates that account balances of less than A$6,000 make up more than 40% of all superannuation accounts (based on 2015-16 data).

Australia's high levels of superannuation member disengagement and the tarnished image of the life insurance industry means there is a risk that affected members will not opt-in to life insurance in large numbers. This would result in a material decline in group risk premiums, which would impact significantly on the revenue of large group risk insurers. It is also expected that insurers would lose predominantly younger policyholders because of the reform, who are likely to claim less than older members and whose premiums often currently cross-subsidize older cohorts. This would result in an increase in the risk of these insurance pools and a consequent worsening in insurers' claims rates. While price rises are inevitable should the proposal go ahead as drafted, it will be somewhat of a balancing act, in our view. On the one hand, life insurers need to be careful not to pull the price lever too aggressively such as to discourage members in general from retaining their coverage, but enough to ensure they do not write unprofitable business.

We expect that insurers will face significant challenges in meeting the start date of July 1, 2019, should the package proceed as proposed. The proposed changes will require insurers to make substantial system and process changes to implement them, and will also necessitate the renegotiation of existing contracts with trustees. Some insurers have publicly cast doubt on whether they would be ready to implement the proposals under the current timeframe.

With the proposed implementation date for the changes looming and the legislation yet to pass parliament, a deferral of the implementation date seems a distinct possibility. Indeed, at this stage, whether the proposals will actually proceed or not is unclear. As a result of the various impacts of the package, there has been strong opposition to it from around the industry including from life insurers, trustees, industry bodies, and consumer groups. All that is certain is that, if it does pass parliament as currently proposed, the package will have significant adverse consequences for large group risk writers.

Modest Returns Spur Australian Owners To Divest Life Insurance Operations

The returns for the overall Australian life insurance industry (including wealth management) are considered reasonable. However, the return on equity performance and the prospects for pure life operations have been rather modest and not acceptable to many owners, especially banks. Consequently, five groups, three of which are major Australian banks, have divested or announced the sale of their life risk operations since 2016. This has triggered a substantial shift in market dynamics with the five sales to date accounting for over a third of the sector's market share as measured by inforce annual risk premiums. The trend may yet to be over with financial conglomerate AMP Ltd. having identified its life insurance risk business as a possible candidate for divestment as part of a portfolio review.

Table 1

The changes herald an increase in market concentration, with the top four players likely to account for over 70% of the market as measured by inforce annual premium--and all owners offshore. Chart 2 shows market share post transaction settlement. In a few short years, the sector has gone from one dominated by bank owned insurers--over 40% of the market--to Westpac Life Insurance Services Ltd. (A+/Stable) being the sole major bank owned participant. As many of the new owners are operating in low yield environments, they are likely to accept lower returns than prior owners and, as a consequence, upward premium pressure may reduce somewhat. We consider the creditworthiness of the new owners as strong, being in the 'A+' to 'AA-' range.

Chart 2

A Challenging Period Ahead

The next year will remain challenging for the Australian life insurance sector. The full extent of the difficulties are yet to play out but should become clearer once the Royal Commission recommendations (and government response) are known early in 2019 and when there is clarity as to the extent to which the Protecting Your Superannuation reforms are to be implemented.